America has a profit problem

Warren Buffett has become one of the airline industry’s biggest investors after calling the business a “death trap” for investors back in 2013. (Sign up for our free video newsletter here http://bit.ly/2n6VKPR)

Warren Buffett has become one of the airline industry’s biggest investors after calling the business a “death trap” for investors back in 2013. (Sign up for our free video newsletter here http://bit.ly/2n6VKPR)

The economic system is rigged against workers and consumers, says a slew of recent academic research.

A fresh batch of academic studies suggest that the election-year rants of Bernie Sanders and Donald Trump were basically correct: The economic system is rigged, as American business owners enjoy unusual power to extract wealth from workers and consumers.

The evidence is almost everywhere economists look. Conglomerates are bigger, fewer and more focused. Stock ownership is becoming concentrated in a modern twist on Gilded Age trusts. Stunted rates of small business startups ensure that fewer giants are toppled.

Such trends are bully for long-term investors in stock markets, which have stormed back into record territory. Less so for workers, who on average haven’t seen much in the way of raises this century, or for consumers, whose long feast on cheap imports appears to be ending with rising inflation and a hangover of personal debt.

In a well-functioning economy, these kinds of imbalances can arise but are usually competed away relatively quickly. That’s not happening this time.

Shrugging off the Panic of 2008, profits of the largest U.S. public companies in the S&P 500 Index have doubled since 2003, according to research by Aswath Damodaran, a New York University finance professor. Measured in earnings per share, profit hit a record $113 in 2014, dipped slightly the next year before recovering in 2016 to nearly $109 per share.

Not coincidentally, the value of the S&P 500 has about doubled right along with profits, from 1,111.91 in 2003 to a closing price Friday of 2,378.25.

Just as important as rising profit has been its persistence. Last year the operating profit margin of the S&P 500 reached 10.4 percent, near the 2014 peak and well surpassing the economic boom years of the late 1990s (about 7 percent) and 2007 (9.5 percent average margin), Yardeni Research reported last week.

Indeed, a very profitable U.S. company in 2003 had an 83 percent chance of remaining that way a decade later, up from a 50 percent chance in the 1990s, estimates McKinsey, the consulting firm.

And the bounty has come mostly from domestic consumers, with American firms earning returns on equity 40 percent higher in the U.S. than from abroad, according to The Economist.

Now as always, profit is the fuel that powers the engine of healthy market capitalism. Profit-seeking is generally why inventors innovate. A dearth of profit prevents capital from being wasted on fruitless pursuits.

Yet too much profit is unhealthy, a classic sign that competition is lacking. There are other signs.

Weaker competition and higher concentration is evident in more than 75 percent of U.S. industries, reports a paper released last month by Gustavo Grullon of Rice University, Yelena Larkin of York University and Roni Michaely of Cornell University.

After adjusting for inflation, the average publicly traded firm is three times larger than it was 20 years ago. Much of this consolidation came during a $10 trillion wave of mergers since 2008.

So extreme is this merger boom that U.S. stock markets have lost nearly 50 percent of their publicly traded firms. The number of listed companies is lower than the early 1970s, even though today’s gross domestic product is three times larger after adjusting for inflation, says a paper published last year by German Gutierrez and Thomas Philippon of New York University.

Even the rising popularity of mutual fund investing may be boosting profits at the expense of consumers, concludes a provocative paper revised last week by Jose Azar of University of Navarra, Martin Schmalz of University of Michigan and Isabel Tecu of Charles River Associates.

Nearly half of the stock in American Airlines is controlled by seven big investors who are among the top 10 investors in Southwest Airlines, they found. In turn, five of Southwest’s largest shareholders are in the top 10 at American, Delta and United. Increasingly, these big investors are institutions, chiefly mutual funds and firms that deploy pension savings.

Economists since Adam Smith have noted that two companies controlled by the same few owners will tend to compete less vigorously. Using 14 years of ticket data, these three academics calculate that U.S. airfares are 3 percent to 7 percent higher because of common ownership.

More dramatically, they estimate that U.S. ticket prices surged 10 percent after Black Rock, a giant mutual fund company, bought Barclays Global Investors’ equity portfolios in 2009. The result was increased concentration in airline ownership.

Such newfound pricing power has attracted the attention of Warren Buffett, who has scooped up shares of the Big Four domestic airlines over the last year. This is the same Buffett who quipped in 1999 that a farsighted capitalist should have shot down Orville Wright at Kitty Hawk in 1903, so as to avoid the century of operating losses in the airline industry that followed.

Speaking of Buffett, last year Bloomberg said his Berkshire Hathaway had already earned $22 billion in dividends on its $34 billion purchase of Burlington Northern Santa Fe in 2010. Such are the benefits of consolidation in the railroad industry, where returns on capital have doubled as freight prices surged 40 percent since 2004.

Buffett loves to cultivate a friendly, folksy image. But as an investor, he loves nothing more than extreme lack of competition.

Healing what ails American capitalism won’t be easy. Solutions offered by Trump and Sanders seem likely to make matters worse.

In particular, government regulation tends to entrench incumbents with big lobbying budgets.

More regulation, the Sanders approach, seems likely to turn out no better than the previous round. Bank lending to small business still suffers from post-2008 financial reform, and Obamacare has sparked a major health care consolidation.

Similarly, Trump’s threats of import quotas and tariffs are poised to lift input prices for smaller firms, conferring yet another advantage to multinationals that can easily move production.

However, government can help matters if it can improve competition.

Modernizing the formulas used by federal economists would allow antitrust lawyers to more intelligently challenge deals that hurt consumers. Just policing more might help. Enforcement declined steadily under Presidents George W. Bush and Barack Obama, with antitrust actions hitting a modern low in 2014, at the height of merger activity.

Shareholder-driven reform of corporate governance offers potential, too. The same study that found peril for consumers in cross-ownership also found increased competition after an activist investor agitated for management changes at a major firm.

And technology and revived globalization may ride to the rescue, as it did in the 1990s. For every comfortable leviathan like Google or Facebook, there’s an Uber engaged in mortal combat with a Lyft on its turf, not to mention losing China to a Didi, the fast-growing nation’s largest ride hailing service.

History suggests that, with time, today’s fat profits will eventually draw competitors. But it sure would help consumers if government stopped inhibiting them.

CAPTION

If the deal is successful, Aetna would gain more information on patients by having access to data from CVS clinics and retail counters. (Dec. 4, 2017)

If the deal is successful, Aetna would gain more information on patients by having access to data from CVS clinics and retail counters. (Dec. 4, 2017)

CAPTION

If the deal is successful, Aetna would gain more information on patients by having access to data from CVS clinics and retail counters. (Dec. 4, 2017)

If the deal is successful, Aetna would gain more information on patients by having access to data from CVS clinics and retail counters. (Dec. 4, 2017)

CAPTION

An intensifying debate between the climate change skeptics looking to strike a death blow to federal greenhouse gas restrictions and a growing chorus of electricity and manufacturing companies warning that such a move would backfire could ultimately test who has the most White House clout in setting energy policy. (Nov. 30, 2017)

An intensifying debate between the climate change skeptics looking to strike a death blow to federal greenhouse gas restrictions and a growing chorus of electricity and manufacturing companies warning that such a move would backfire could ultimately test who has the most White House clout in setting energy policy. (Nov. 30, 2017)

CAPTION

The underlying technology securing bitcoin is known as the blockchain. (Nov. 29, 2017) (Sign up for our free video newsletter here http://bit.ly/2n6VKPR)

The underlying technology securing bitcoin is known as the blockchain. (Nov. 29, 2017) (Sign up for our free video newsletter here http://bit.ly/2n6VKPR)